If you’re serious about building wealth, it’s crucial that you take a diversified approach. It’s a simple concept, but one that many investors – including high earners – often get wrong.
Here, we are going to look at the basics of asset diversification and explain why it’s important. We will also provide some tips for high earners who are keen to diversify their portfolios.
What is asset diversification?
Diversification is the process of spreading your capital out over a range of different assets (or asset classes) in an effort to lower your overall investment risk and increase your potential returns. The idea is to limit your exposure to individual assets so that your returns – and your financial goals – are not compromised if certain asset classes underperform for a period or do not provide the returns that you might usually expect.
Asset diversification does not eliminate investment risk entirely. However, it is a sound risk management strategy that can give you a much better chance of success when investing for the future.
Why asset diversification is important
Diversification is important for a number of reasons.
For a start, it can significantly lower your exposure to risk. If you own a properly diversified portfolio, you are unlikely to be impacted significantly if a few of your investments underperform over a short period of time.
It can also help to smooth out returns. Different asset classes tend to react differently to political and economic news and developments, diversified portfolios tend to be less volatile than concentrated portfolios. Knowing that your portfolio is diversified – and that it is unlikely to suffer a major drawdown – can provide peace of mind, especially during periods of market turbulence.
Finally, asset diversification can also help to increase your long-term returns. Typically, a portfolio made up of different kinds of assets will outperform an investment in an individual security over the long run. Ultimately, a solid portfolio delivering steady returns tends to win the race in the long term.
How to diversify your assets
A well-diversified portfolio will be diversified both across and within asset classes. So, at a headline level, you would expect to have exposure to all of the major asset classes, such as:
- Alternative assets
But then you will also have diversification within these asset classes.. For example, the stocks (equities) component of the portfolio will be diversified across sectors (Financials, Technology, Healthcare, etc.), geographies (UK, US, Europe, Asia, etc.), and market capitalisations (large cap, small cap, etc.). Similarly, the bonds component of the portfolio will be diversified across different areas of the bond market such as government bonds, investment grade corporate bonds, and high-yield bonds. By diversifying, investors can dramatically lower their portfolio risk levels and give themselves a much greater chance of financial success.
How correlation plays a role in asset diversification
An important concept when it comes to asset diversification is ‘correlation’. This is a statistical measure that indicates how assets move in relation to each other. When assets move in the same direction at the same time, they are said to be positively correlated. Conversely, if one asset tends to move up when the other moves down, the two assets are said to be negatively correlated. By combining assets that have a low or negative correlation to each other (e.g. stocks and bonds), you can potentially lower your risk levels.
Asset diversification versus allocation
When building a portfolio, it’s crucial to focus on both diversification and allocation. While asset diversification is the process of spreading your capital out across and within different asset classes, asset allocation is the process of deciding how much capital you will allocate to each of the different asset classes.
Your goals, time horizon, and risk tolerance will determine your optimal asset allocation. For example, if you have a long-term investment horizon and a high tolerance for risk, you may be better off investing more of your capital in higher-risk, higher-reward assets such as stocks. On the other hand, if you have a short-term time horizon and a low tolerance for risk, you may be better off focusing on lower-risk investments such as bonds and cash savings. If you are unsure about the best asset allocation to pursue it can be a good idea to speak to a wealth management expert.
It’s worth pointing out that asset allocation alone is not enough to effectively manage risk. After all, allocating 100% of your capital to one asset class won’t offer much protection if that asset class collapses in a market downturn. This is where asset diversification comes in.
How alternative assets can help investors diversify
Alternative assets are investments outside traditional asset classes such as stocks, bonds, and cash. They can include investments in commercial property, commodities, private equity, hedge funds, structured products, and other assets.
Alternatives can be useful from an asset diversification perspective because they generally have a low correlation to traditional asset classes meaning that they can help to lower portfolio volatility. At the same time, they can offer investors new sources of return. By investing in alternative assets, investors can potentially create more balanced portfolios that are superior from a risk/reward perspective.
Asset diversification tips for high earners
When diversifying their investment portfolios, there are a few things that high earners should consider.
Asset concentration is one. Often, the wealth of high earners is concentrated in a specific asset or group of assets. For example, individuals that work for publicly-traded companies often own a substantial amount of company stock. It’s important to factor this in when constructing an investment portfolio and invest in uncorrelated assets. Working with a wealth management expert that has experience with high earners can be sensible here.
A second factor to consider is ‘human capital’. Human capital can be defined as the present value of your future wages. While this asset is intangible, it’s often the single largest asset an individual has. High earners should look to reduce their risk levels by investing in assets that have a low correlation to their human capital. Again, working with an expert can be beneficial here.
How Bowmore can help you diversify your assets
At Bowmore, we specialise in helping high earners build diversified long-term investment portfolios.
Whatever your reason for choosing to invest, we can help you build and maintain a well-diversified portfolio that is in line with your risk levels and designed to help you achieve your individual goals.
To find out more about how we can help you diversify your assets, get in touch here.
BOWMORE FINANCIAL PLANNING
Phone: 01275 462 469
- Bowmore Financial Planning Ltd is authorised and regulated by the Financial Conduct Authority
- The value of your investments can go down as well as up, so you could get back less than you invested
- Past performance is not a guide to future performance